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The Worst Investment I've Ever Seen

In the interest of full disclosure, the absolute worst investment I've ever seen is an advance-fee offer from a long-lost Nigerian pen pal named Dr. Clement Okon -- a man who knows neither the proper use of a thesaurus nor how to turn off CAPS LOCK.

Just how bad is this investment? According to a report in The San Francisco Chronicle, "Dr. Okon" and his, er, colleagues bilked Americans for a record $198.4 million in Internet fraud in 2006 -- with the "notorious 'Nigeria 419' scam ... blamed for the largest individual losses."

When bad comes out of goodAlthough not as bad as the Nigerian scam, the worst stock market investment I've ever seen has also cost Americans a ton of coin -- but it's 100% legal.

Before I name names, some background: Index funds and exchange-traded funds are hugely popular. Hundreds of billions of dollars are tied up in index funds; the mammoth S&P 500-tracking Vanguard 500 Index (FUND: VFINX) alone holds more than $80 billion in total assets.

As I've written before, this is a decidedly good thing. With so many active funds failing to beat that one bogey -- the large-cap-laden S&P 500 -- while charging more in fees, betting with the house is a sound strategy. Indexing gives you instant diversification, low turnover, and, best of all, low costs.

So the theory goesTake the very first index fund, for instance. Vanguard 500 has an expense ratio of 0.15%. It has no loads, 12b-1 marketing fees, or other hidden costs. So for every $100 you invest in Vanguard 500, you're dinged $0.15. Good deal, right? Hold that thought.

The First American Equity Index fund is also an S&P 500-tracking index fund. According to the fund's website, its objective is to "provide investment returns that correspond to the performance of the S&P 500 index." As you'll see, it's nearly identical to the Vanguard offering:

Data from Morningstar. VFINX holdings as of June 30, 2008; FAEIX holdings as of Sept. 30, 2008.

That's just a sampling. The allocations to smaller S&P 500 holdings such as Merck (NYSE: MRK) , Comcast (Nasdaq: CMCSA) , and Monsanto (NYSE: MON) will have about the same slight variance.

The holdings are almost identical -- and once the Vanguard holdings are updated through the last quarter, they'll be even closer -- but the fee structure is not. Here's what shares of First American Equity Index cost:

Yes, you read that right: This is an index fund with a hefty front-end sales load and an expense ratio more than three times the size of its most notable competitor.

It's no small fry, either -- the fund has $1.1 billion in total assets.

More where that came fromI don't mean to single out First American Equity Index; it's not the only outrageously costly index fund:

Fund

Load?

Expense Ratio

Total Assets

Munder Index 500 (MUXAX)

2.5% front-end

0.60%

$391 million

BlackRock Index Equity (CIEAX)

3.0% front-end

0.36%

$590 million

Morgan Stanley S&P 500 Index (SPIAX)

5.25% front-end

0.58%

$610 million

Nationwide S&P 500 Index (GRMAX)

5.75% front-end

0.49%

$1.7 billion

Data from Morningstar.

High-fee index funds don't bring any performance advantages to the table, and they siphon off more of our money to the pockets of the fund companies. Indeed, Morningstar estimates that an investment of $10,000 in FAEIX will cost you $1,428 in fees over a 10-year period. That same investment in VFINX will run up $192 in fees. Do you see any reason to pay $1,236 more for the exact same product?

Me neither. And there you have it: The worst investment I've ever seen is the outrageously expensive index fund. Seriously. If you had two street vendors offering you the same product, and one of them charged substantially more, which would you choose?

That's a rhetorical questionIn the marketplace, reason should lead us to the less-costly choice. But -- as the last column in the above table illustrates -- that's not the case with mutual funds.

In a paper titled "Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds," professors James Choi, David Laibson, and Brigitte Madrian reinforce that point.

The trio presented Harvard staff members and undergraduates and Wharton M.B.A. candidates -- a decidedly brainy sampling -- with a $10,000 portfolio. Each subject was to allocate the $10,000 across four S&P 500 index funds; the professors provided different groups with different information about the funds.

Now, the single differentiating factor among the choices is how much they charge -- they're S&P 500 index funds, for crying out loud! But the conclusions were sobering: "Many people do not realize that mutual fund fees are important for making an index fund investment decision. ... Second, even investors who realize fees are important do not minimize index fund fees."

Putting theory into practiceThe fund companies justify the higher fees by saying that they come with financial advice/guidance. Here's the thing, though: If your broker isn't telling you to buy the cheapest index, you should be suspicious of that advice, anyway.

So make sure you're not unwittingly holding an index fund that'll slowly steal your dollars (pay close attention to your 401(k)s, in particular). And make double-sure you pay close attention to all of the fees you're paying when you invest. My colleague Robert Brokamp offers a wonderful service called Motley Fool Rule Your Retirement, and in his model portfolio section, he provides a short list of the best index funds around. To see the funds that have made the cut, and for retirement guidance of all stripes, I encourage you to try the service for the next 30 days, free of charge.

This article was first published July 3, 2008. It has been updated.

Brian Richardsuses hyperbole sometimes. Brian owns shares of the Vanguard 500 Index fund, as well as Microsoft. The Fool owns shares of Pfizer. Microsoft, Pfizer, and Wal-Mart are Inside Value recommendations. Pfizer is also an Income Investor pick. The Motley Fool's disclosure policy is the greatest disclosure policy in human history.

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

I have a question though. Maybe the fund shop that sells this fee laden offering uses it as a vehicle for a portion of investors moneys. Say 10% in this fund with 90% in other more targeted funds (international, hedging etc) generating a specific targeted return startegy (of which 10% S&P is only a small part).

Still, I guess the portion managed as an index fund shouldnt cost this much.

The issue that I have with most 401K's is that you don't really have any alternative. If you want an index fund they usually offer only one.

If you don't get any employer matching you really need to trade off the tax expenses against the fund charges to see if it's worth putting money into a 401K. Sadly, it's becoming more common for employers to end perks like matching 401K contributions.

AT 5.5%, this means that your $100,000 investment loses $5,500 the first day.

End result, over 10 years, EVEN AT THE SAME LOW EXPENSES of say, 0.09%, the difference after 10 years (at 8% gain y.o.y.) that FE load actually costs @2,373 in lost investment gain.

Look at Sharebuilder - looks like a neat way to get your kids interested. Try putting $50 a month into 4 stocks, and you'll pay $16 for the privilege, investing only $34 - a loss of 32%. If the market gains 8% a year it'll take 5 years to break even (34 * 1.08 * 5 = 49)

It seems to me that the trick would be to invest in the mutual fund companies, not the mutual funds themselves. Thus, we should invest in Morgan Stanley and Nationwide, not their mutual funds, since they have the highest fees and loads of those shown above. Who knows, they may not even be the most expensive ones. I would not actually try this today, but I once did that. I invested in Dreyfus Corp, not their mutual fund, a long time ago. Their fund dropped a bit at the time, but the corporation itself did very well. I then sold the shares on the corporation at a nice profit. This was about 40 years ago. They may have had only one mutual fund at the time.

Sending report...

Now: I work on global strategy for The Motley Fool with a focus on Canada, Europe, and South America. Former: Managing Editor of Fool.com. The longer version: http://www.linkedin.com/pub/brian-richards/31/164/461/.